Corporate Finance and Position of Banks

1. Foundations of Corporate Finance & Financial Management

The finance field involves three complex interrelated areas as follows:

The key aspects of financial decision making relate to financing, investment, dividend and working capital Management. Therefore, financial management provides a conceptual and analytical framework for financial decision making. In corporates, finance primarily involves acquisition and allocation of funds and resources with the objective of maximizing the wealth of shareholders. Financial management deals with acquiring and deploying funds from various equity and debt instruments and their investment in the income generating assets to reap benefits.

At a primary level corporate finance helps in generation of funds both from internal and external sources in an economical manner to keep costs low. Funds from external sources are often acquired from venture capitalist, financial institutions or through tapping stock markets. Stock markets facilitate the raising of resources through equity shares, debentures and bonds to the general investing public besides Indian and foreign institutions. In order to leverage the equity, corporations approach banks and financial institutions for raising debt funds.

Corporate finance, as a next step, deals with investment of funds with the objective of increasing wealth of shareholders. It is the job of the Chief Financial Officer or financial controller to conduct both the functions of acquisition of the funds and their investment in a manner that maximises wealth of shareholders. CFO’s must balance the interest of owners, i.e., equity shareholders, creditors and other stake holders in a sustainable manner so that business grows without any adverse impact on society and ecology.

At times the corporations may deliberately choose to invest its resources in risky ventures in an effort to generate large profits for the shareholders. Per se, rewards are directly related to returns. Conversely, risky investment would reduce the perceived security of the Bonds resulting in increased rate of interest that the organisations pay to borrow money in future. Alternatively, if the business invests the resources too conservatively it would fail to maximize its value of business and the returns it provides. Thus, finance managers have to generate better returns from the investments while protecting the image of the company amongst the creditors, banks and bond holders. Banks provide credit to different sectors for the growth of economy.

2. Sectoral Deployment of Gross Bank Credit

Table 1 reflects the deployment of gross bank credit in various sectors for the growth of the economy across Agriculture, Industry, Services, and Retail segments:

3. Global Financial Crisis & Macro-Economic Recovery

History has shown that India is able to deal with crisis in an effective manner sooner or later. The current pandemic has led to financial crises for many economies across the world. Businesses go through cycles of highs and lows. Earlier in the year 2008 a crisis shook the world triggered by the collapse of Lehman Brothers, a global financial services firm. The US based firm filed for Chapter XI – Bankruptcy Protection following the massive exodus of most of its clients, substantial losses in its stock and devaluation by credit rating agencies. The debacle was largely contributed by involvement of financial services in the sub-prime mortgage.

The ten-year yield of Government Bonds in India dropped from 9% to 5% by the end of 2008. The Central Government expanded the Fiscal deficit to 2.5% of GDP in FY2008 to 6% in FY 2009 and 6.5% in FY 2010. As a result, India’s GDP growth rose to pre-crisis level in 2010. Consequent to global financial crisis of 2008 there was a catastrophic meltdown of the global financial markets. The impact on Indian economy was less severe because of our lower dependence on export markets and the sizable contribution to GDP is from domestic sources.

The report on Trend and Progress on Banking in India released by Reserve Bank of India provides graphic description of the status of Financial sector in the country. In the years following financial crisis the negative implication of stressed assets gradually reduced and new slippages were arrested. The Banking sector returned to profitability in the first half of 2019-20. Recapitalisation of public sector banks has helped in improving their capital ratios. The Insolvency and Bankruptcy Code has helped in enhancing resolutions. The private sector Banks have maintained momentum in credit growth. However, overhang of NPAs still remains high and the turnaround would be expected only on reversal in macro economic conditions.

The Scheduled Commercial Banks (SCBs) recorded secular deceleration in deposits right from 2009-2010. However the trend was reversed and deposits constituted 77.6% of the total liabilities of SCBs at the end of March 2019. Demonetization induced a spike in deposits in 2016-17. The revival in the growth of loans and advances started in 2017-18 and the same momentum was maintained into 2018-19.

4. Non-Bank Sector, Spreads, and Contingent Liabilities

The outlook for the non-bank sector consisting of housing finance companies (HFCs) and non-banking finance companies (NBFCs) remained ‘negative’. During 2018-19 credit flow from HFCs and NBFCs declined; on the contrary a sharp rise in commercial paper issuances, higher accommodation provided by all India financial institutions and pick up in net-flows from foreign sources gained momentum. External Commercial Borrowings (ECBs) and Foreign Currency Convertible Bonds (FCCBs) registered net inflows for the first time in four years. Further, Foreign Direct Investment (FDI) flows grew at 18.9% in 2018-19. There is a need to improve the credit-to-GDP ratio to support higher economic expansion.

The size of contingent liabilities of all SCBs increased to 1.2x of their on-balance sheet position at end of March 2019, driven primarily by expansion in forward exchange contracts. Foreign Banks and private sector banks recorded significantly higher off-balance sheet exposure than Public Sector Banks.

5. Capital Adequacy, Asset Quality & IBC Resolution

The financial sector performance of SCBs reported positive net profits in H1 2019-2020 reflecting slackening provisioning requirements. The provision coverage ratio (PCR) improved to 61% by end September 2019 for all SCBs. The leverage of SCBs was reported at 6.6% at the end of March 2019, much above the prescription of 3% by the Basel Committee on Banking Supervision. Further, the Basel III framework prescribes two minimum liquidity standards viz. the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The GNPA ratio of all SCBs declined in 2018-19 after rising for seven consecutive years as recognition of bad loans neared completion. Recovery of stressed assets improved during 2018-19.

Recovery of Stressed Assets: The banking sector continues to be marred by Non-performing assets. NPAs in larger borrower accounts [exposure of ₹ 5 crores or more] had contributed 91% of total GNPAs in 2017-18, after the RBI withdrew various legacy restructuring schemes. During 2018-19, propelled by resolutions under the Insolvency and Bankruptcy Code (IBC), recoveries contributed more than half of the total amount recovered. However, recovery rates yielded by major resolution mechanisms declined in 2018-19 especially through the SARFAESI mechanism.

The classification of Loan Assets Bank group-wise as reflected in Table 4 demonstrates that there is no appreciable growth in the percentage of Standard Assets. At the same time, the percentage of Sub-standard Assets recorded an improvement from 2.8% to 1.9%, but the amount of Loss Assets recorded a high level and increased from 0.6% to 0.8%. Cases referred for recovery through legal mechanisms shot up, whereas cleaning up of balance sheets via sales of stressed assets to Asset Reconstruction Companies (ARCs) decelerated on a YoY basis.

6. Financial Frauds in Banks: Risk Profile & Modus Operandi

From time to time banks have also faced financial frauds stressing their assets. Frauds particularly the large ones are difficult to detect, tend to get reported with a lag and have significant implications. The number of cases of fraud reported by Banks as well as the amount involved increased during 2018-19. In February 2018 the government issued a framework for timely detection, reporting and investigation relating to Frauds in PSBs. The framework required banks to evaluate NPA accounts exceeding ₹ 50 crores from the angle of possible frauds as a tool to unearth large fraudulent transactions at an early date. Consequently, there was a sharp rise in reported frauds in the year 2018-19.

7. Endnote & The Role of Chartered Accountants

The banking system plays a crucial role in the growth of Indian economy. The problems of banks, accentuated by a variety of factors, can be improved by putting proper governance mechanisms in place. Chartered Accountants functioning diligently and following well established standards can also help the banks.